As the Senate debates the issues addressed by S. 2155, specifically the leverage ratio, the Systemic Risk Council (SRC) reiterates its previous statement that the leverage ratio should not be altered in ways that create or exacerbate systemic risk. Our most recent statement on this issue, excerpted from a letter to Senators Crapo and Brown regarding S. 2155, is set forth below. The full letter is appended to this statement.

Supplementary Leverage Ratio

As the Committee knows, the requirement that banks keep their leverage (broadly the ratio of total assets to equity capital) below a certain level was introduced because of the risks in relying on a risk-weighted minimum capital requirement. Those risks arise because of the mistakes that can be made by regulators and bankers in gauging the riskiness of particular assets and exposures. In particular, reliance of banks’ internal models gives bankers incentives to shade down their estimates of risk, effectively leaving them the choice of how much capital to carry to back their business. Given that the whole purpose of bank regulation is to overcome the problem of the social costs of banking distress and failure exceeding the private costs to bankers and their equity holders, allowing the banks to essentially self-regulate their capital would be perverse.

In consequence, the leverage ratio was introduced as a backstop. The more that individual banks stretch the limit of the risk-weighted ratio, the more the backstop will bite. That is the point.

The central feature of the leverage ratio is that it makes no distinction between assets and exposures. The Bill proposes that policy depart from that simple system. In particular, it proposes that reserves (broadly, deposits) held by banks with the Federal Reserve should be excluded from ‘total assets’. There are further suggestions that initial-margin moneys placed by banks with central counterparty clearing houses (CCPs) should also be excluded.

This would, we fear, be the thin end of the wedge. The history of bank regulation in the US is of progressive dilutions of core regulatory requirements over a number of years, leaving the banking system as a whole vulnerable to crisis. Preserving the principle that ‘total assets’ means total assets is important if the American people (and wider world) are to be adequately insulated against financial instability.

More specifically, the SRC recognises that there are special circumstances where reserves should be excluded from ‘total assets’ in order to remove a binding constraint on quantitative easing (QE)^[1]. But SRC believes that such relaxations of regulatory requirements should be temporary and clearly necessary. Those legislators who were concerned about QE should be wary of making a permanent change to the leverage ratio that would make QE easier for the central bank. The final version of Basel 3 provides for such temporary relaxations, but does not make them a permanent feature of the system.

On the question of initial margin moneys (IM) placed with CCPs, SRC recognises that these exposures are low risk where two conditions hold: (a) that the IM is held bankruptcy remote from the clearing house, and (b) that the IM is invested on behalf of the banks in very low-risk assets such as Treasury Bills. But even then these exposures are not risk-free, because banks’ rights to the segregated assets could be challenged in the event of CCP distress or bankruptcy.

We would make one final comment on this issue. It is sometimes suggested that the leverage ratio is fundamentally ill-suited to custody banks, essentially on the grounds that the services they provide are conducted off-balance sheet. Of course, to the extent that such services are provided on a pure agency basis, there is no balance sheet activity and, thus, the leverage ratio would be irrelevant. In fact, a material source of custody banks’ profits come from providing services to their clients via their balance sheets: trading revenue and net interest margin. Those are unavoidably risky. Given the extraordinary concentration of the US custody business, itself a source of systemic vulnerability, it is immensely important that the custody banks be super resilient. Relaxations designed to help them could lead to perverse effects. If the leverage ratio bites, they could act as agents on-placing customer deposits with other banks (or in Treasury Bills or funds) rather than always taking them onto their own balance sheets.

[1] Technically, the central bank cannot use QE to create more reserves than is consistent with the leverage ratio. That is because where QE is used to buy securities from non-banks, the total assets of banks are increased, raising actual levels of leverage.

Read the full letter here: Systemic Risk Comment Letter to U.S. Senate